A tale of two cities
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Emerging Markets

A tale of two cities

The European Union’s newest members are in grave danger of a hard landing. Policy chiefs in both Sofia and Bucharest face an impossible choice

By Sid Verma


The European Union’s newest members are in grave danger of a hard landing. Policy chiefs in both Sofia and Bucharest face an impossible choice


On the face of it, Romania and Bulgaria, the EU’s newest members, are in the throes of an historic makeover: both are enjoying rapid growth, at 8% and 6% respectively; unemployment has been falling steadily; capital is gushing in; and newly empowered citizens are prospering as never before.


But analysts are increasingly worried that the fruits of this rapid turnaround could be short-lived. Rating agencies, the IMF and the EU are all warning that the economies of both countries are in danger of overheating.


“The situation is worsening as time goes by,” says Lars Christensen, senior analyst at Danske Bank. “The probability of a soft landing is decreasing.”


Foreign financiers poured E9 billion into Romania in 2006, thanks to booming domestic demand and the promises of deeper EU integration, while the IMF project E9-10 billion in 2007. Bulgaria also attracted an impressive E4.015 billion in 2006. In both countries, rapacious demand for consumer and capital goods has caused current account deficits to swell at alarming rates; Bulgaria’s deficit has increased from 6.6% in 2004 to 15.8% in 2006, and Romania’s has increased in the same period from 8.4% to 10.3%.


For the shoppers with new-found credit gracing the newly built malls in Bucharest and Sofia, such deficits signal the reward for tough structural changes, after the food shortages during the last days of communism and the subsequent pain of high unemployment. Their incomes are catching up with their wealthier EU neighbours’. And the deficits are financed largely by foreign investment, avoiding a heavy build-up of private-sector external debt.


The question, though, is whether the region is attracting the right sort of investment. Daniel Daianu, economics professor in Bucharest and former finance minister for Romania, is worried: “We want FDI inflows into productive investments, but unfortunately we are seeing lots of speculative inflows,” he says.


In particular, the failure of exports to keep pace with imports clearly suggests that both portfolio and direct investment are focusing on domestic activities, rather than stimulating export-generating capacities that will eventually allow these countries to bridge the budget deficit. Indeed, 15% of FDI in Romania in 2006 went to retail and wholesale trading operations. Moreover, R&D is only expected to rise to 0.7% of GDP in 2007 – far off the Lisbon Agenda requirement of 3%. In Bulgaria, hot money is pouring into the real estate sector, and manufacturing investments are actually declining. Rather than concentrating on shops, the economy needs to concentrate on fixed investments in technology, services and manufacturing.


Current account concerns


Long-term competitiveness is not the only challenge: as the current account deficits widen, these countries are clearly vulnerable to a change in investor sentiment that could expose them to an external financing shortfall. Kennet Orchard, credit analyst at Moody’s, cautions: “A growing budget deficit in a period of rapid economic growth indicates that fiscal policy is strongly pro-cyclical. This is an especial concern, given the large current account deficit and incomplete disinflation process.”


Under the shadow of this risk, economists and policy-makers are urgently discussing ways to manage domestic demand, mindful that domestic credit and external borrowing are surging out of control. But in both countries, monetary weapons to this effect are emasculated.


Bulgaria operates a currency board against the euro, which means that it has effectively transferred its monetary policy to the ECB. In Romania, the central bank is faced with the conflicting demands of controlling inflation, keeping one eye on the strength of the leu, which could render exporters uncompetitive.


Any monetary tightening would risk drawing in more foreign capital, exacerbating the exchange rate appreciation and current account deficit. Furthermore, in both countries, an open capital account and high proportion of foreign currency lending in the financial sector means monetary policy cannot control domestic demand.


Florin Citu, chief economist at ING Bank, Romania, says that, due to these structural issues, both countries “need to work on fiscal policy, not monetary policy”. However, the Romanian government forecasts a fiscal deficit of 2.8% of GDP in 2007, with the IMF warning that failure to increase revenues, reallocate expenditure and tighten current spending in the face of EU-related spending pressures could see the budget deficit widen to as much as 3.8% of GDP this year. Analysts are warning that fiscal loosening has negative consequences for the credit rating.


Francesca Pissarides, senior economist and lead economist for EU accession at the EBRD, believes fiscal restraint is more likely in Bulgaria: “The currency board structure makes the adoption of prudent fiscal policies more likely,” she says. Bulgaria ran a budget surplus of 3.6% in 2006, yet only set itself a target of 2.3% this year. But the IMF warns the country needs to offset the large private-sector saving and investment imbalances by running a budgetary surplus of over 3%.


Public pressures


Yet both governments still face public pressure to invest in health, education and infrastructure, fulfilling pre-EU accession commitments that membership will bring substantial benefits to these essential services. Raphael Marechal, who co-manages the E430 million Fortis Emerging Europe Bond Fund, believes that such demands and complacency in Romania are affecting investor sentiment: “Fixed income investors are worried by the macro-fundamentals, and fiscal policies are simply too loose,” he says.


EU finance ministers also say, in a ruling adopted in Brussels on March 27 this year, that Romania’s programme to contain spending is “insufficient and should be strengthened significantly”, while the budget plan “does not seem to provide a sufficient safety margin” against breaching EU deficit rules.


Alarmingly, Romania’s minister of economy and finance minister, Varujan Vosganian, has suggested that fiscal loosening will not exacerbate current account deficit problems: “The economic policies will target fiscal deficits, and continuing disinflation would be achieved not by fiscal restraints but through economic development,” he commented to a local newspaper.


The reluctance to restrain fiscal deficits due to their negative impact on economic growth makes overheating more likely. The tensions probably stem from the fact that Vosganian has conflicting targets as a fiscal policy-maker and agent for economic growth.


But Daianu believes this economic strategy is completely wrong-headed: “There should be no running of budget deficits, but instead the government should increase tax revenues through clamping down on evasion, controlling public-sector wages and stimulating productivity gains,” he says.


A potential sharp pull-back in the Romanian leu lies at the heart of this correction scenario. Romania’s real effective exchange rate appreciated 50% between 2000 and 2006, while Bulgaria’s rose 34%, purely due to the inflation differential with its trading partners. Marechal believes the Romanian currency is clearly overvalued: “I am surprised the currency is so overvalued despite the ballooning current account deficit,” he says.


Florin Citu expects a depreciation of the currency in the next quarter, but as part of a healthy rebalancing of the economy. “Overheating is occurring, but this will be corrected as a short-term blip after seven years of growth. Investors and banks expect this, but it does not change the region’s good long-term growth prospects.”


Michael Marrese, head of economic research and strategy for emerging Europe at JP Morgan, is also phlegmatic: “Any slowdown will clearly have an impact on credit growth, but we believe pessimism is overdrawn: the growth prospects are very good.” A depreciation will increase the competitiveness of Romania exports, cool the appetite for imports as they become more expensive, and slow domestic demand, helping to close the current account deficit. Of course, this will come at a price: inflation could rise still further in line with the increased cost of imports in leu terms, and those individuals and companies that have borrowed heavily in hard currency will risk bankruptcy.


This makes clear the political danger of a sharp correction in either economy, and the urgency of engineering a soft landing. Both these countries still face economic reform challenges, including public enterprise restructuring, labour reform and improved tax management. If a bust follows the current boom, public support for such prudent policy-making may be even harder to generate.

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